The New York Times on Enron's accounting practices. I've bolded parts:
February 17, 2002
Enron Had More Than One Way to Disguise Rapid Rise in Debt
By DANIEL ALTMAN
A long with the debt it spirited away in partnerships, Enron hid billions in loans in plain sight.
The company took advantage of accounting rules to count large loans from Wall Street firms as financial hedges instead of debt on its balance sheet, according to accountants and industry analysts. The effect was to mask its weakening financial condition.
Records held by Arthur Andersen, Enron's longtime auditor, and people close to the transactions show that Enron received $3.9 billion worth of such loans from 1992 through 2001, including at least $2.5 billion in the three years before the company filed for bankruptcy protection. Those loans were in addition to the $8 billion to $10 billion in long-term and short-term debt that the company disclosed in its financial reports in those last three years.
If Enron had in fact disclosed all the money as debt, then credit rating agencies, industry analysts and investors would have known earlier on that the company was riskier than it appeared.
Partly because of the way the loans were accounted for, the company reported a surge in its hedging activity, accomplished using financial contracts called derivatives, during its last few years. When pressed about the increase by skeptical analysts, Enron officials said the numbers reflected hedges for commodities trades, not new financing, the analysts said.
"They'd always tell us, `Don't worry about that, it's just hedging activity,' " said John E. Olson, the research director at Sanders Morris Harris who was one of the first analysts to challenge Enron's practices.
Enron officials did not answer requests for information on the accounting.
Enron's accounting treatment conformed to existing recommendations from the Financial Accounting Standards Board, the nation's accounting rule maker, said Timothy S. Lucas, director of research and technical activities at the board. But the group will soon reveal a new recommendation, he said, requiring that such transactions be accounted for as loans as well. The board was reconsidering its policy last September, before Enron's collapse.
To keep growing at a brisk pace in its final years, Enron needed billions in financing. Had the company raised the money by issuing more debt or taking out conventional loans, rating agencies might have become concerned and downgraded its credit, making it harder and more expensive for Enron to borrow in the future.
So instead, Enron engaged in sophisticated transactions with J. P. Morgan Chase (news/quote), Citigroup (news/quote ) and Credit Suisse First Boston. Enron entered into derivative contracts that mimicked loans but could be accounted for in less obvious ways. The loans with J. P. Morgan Chase were arranged through a shell company, Mahonia, but the other banks made loans directly to Enron.
From late 1999 through early 2001, Citigroup lent Enron $2.4 billion in a series of transactions known as prepaid swaps, said people close to the deals. In a swap, two parties trade the future returns on investments over a set period of time. For example, one party might pay a small amount to receive a fixed interest rate on a corporate bond in lieu of uncertain gains on the same corporation's stock. The counterparty accepts the payment and swaps the return on the bond for the return on the stock. Neither party actually needs to hold the underlying assets, as long as the payments are made.
Typically, neither party in a swap exchange receives all the agreed payments up front. In these transactions, though, Citigroup paid an estimate of the fair value of its portion of the swaps ? hundreds of millions of dollars each time ? immediately. Enron was obliged to repay the cash over five years, though its payments might have varied with market conditions. The transactions, though technically derivatives trades known as prepaid swaps, perfectly replicated loans.
Citigroup did not answer repeated questions about whether it had booked the transactions as loans.
Credit Suisse First Boston also lent Enron money using trades in derivatives. In 2000, the bank gave Enron $150 million to be repaid over two years. Enron's payments would vary with the price of oil.
Technically, the transaction was a swap. But because Credit Suisse First Boston paid Enron up front, the transaction took on the characteristics of a loan ? a reality noted by the bank. "It was like a floating-rate loan," said Pen Pendleton, a Credit Suisse First Boston spokesman. "We booked the transaction as a loan."
Enron's balance sheet told a different story. The company posted the banks' loans as "assets from price risk management" and possibly, to a far lesser extent, as accounts receivable, said Charlie Leonard, a spokesman for Andersen. The repayments that Enron owed the banks were listed as "liabilities from price risk management" and possibly a small amount as accounts payable, Mr. Leonard said.
Though Enron's accounting treatment conformed to accounting recommendations for prepaid swaps, rule makers intend to change the guidelines. "Under the first guidance, we decided a prepaid swap would be a derivative in its entirety," said Mr. Lucas of accounting standards board. Under forthcoming rules, he said, a prepaid swap would count as a loan as well as an underlying derivative.
Close readers of Enron's financial statements would have seen lines identified as assets and liabilities from price risk management in the assets and liabilities sections. These lines grew far faster than the quantities of commodities traded by the company. From the fourth quarter of 1999 to the first quarter of 2001, price risk management grew to $22 billion from roughly $5 billion in assets and liabilities.
Enron provided little explanation even in the footnotes of regulatory filings.
"There are just so many things that go into assets and liabilities from price risk management that I don't think it's possible to narrow it down," said Jeff Dietert, an analyst at Simmons & Company, a investment bank based in Houston that specializes in the energy industry.
Even after Enron's bankruptcy, analysts said they could not understand the financial statements. "Quite bluntly, those numbers are impenetrable," said Robert McCullough, managing partner of McCullough Research, an energy consulting firm in Portland, Ore.
Had rating agencies known about the additional loans, Enron might have had a harder time obtaining credit in other markets. "Considering that our credit rating was largely based on information now deemed by the company itself to be misleading, inaccurate, and false, it is pretty likely that the credit rating would have been different," said Fran Laserson, vice president for corporate communications at Moody's Investors Service.
The banks had little reason to worry about the swaps cum loans. In Credit Suisse First Boston's case, the amount was relatively small and time involved was short.
Citigroup went a step further by hedging itself against losses on the entire $2.4 billion in Enron exposure. In effect, it bought insurance by making other derivatives trades.
Citigroup set up trusts to sell securities called "linked Enron obligations" and "credit-linked notes," for which investors paid $2.4 billion in principal. Both types of securities paid a constant return unless Enron missed a payment to Citigroup or went bankrupt. In that case, Citigroup would take the investors' principal and replace it with a slice of Enron's debt with the same face value. An investor who held $100,000 worth of the notes when Enron filed for bankruptcy would have received the rights to $100,000 in debt issued by Enron.
The Citigroup trusts could have invested $1 billion of the principal directly in Enron, but they apparently kept the funds in safer investments as insurance.
In the spring of 2001, fuel prices fell. Enron's assets and liabilities in the category labeled "price risk management" dropped sharply.
Falling fuel prices could have explained some of the decline, but Enron did not respond to inquires.
Mr. Dietert of Simmons said that Enron's competitors in energy trading, like Dynegy (news/quote ) and Williams, might also have used derivatives for financing. Both companies list assets and liabilities from risk management on their balance sheets. For Dynegy, those figures grew to $8 billion from about $1 billion between late 1999 and the middle of last year. Steve Stengel, a spokesman for Dynegy, said that the "vast majority" of those figures came from hedges of Dynegy's energy trading, though he did not know the exact breakdown.
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